Embodiments of the present invention are directed to the execution of complex orders for equity options contracts and underlying equities. As discussed more fully below, the present invention is not limited to complex orders for equity options, but is applicable to trading complex orders for other types of financial instruments, for example, index options contracts, futures contracts, stocks, bonds, exchange traded funds, security futures, commodities, treasury instruments, currencies, and the like as well as combinations of such instruments. Known markets for trading these other instruments suffer from the same shortcomings as do equity option markets, and the advantages of the invention are applicable to these instruments as well.
Investors often wish to purchase or sell different option contacts related to the same underlying security at the same time, as part of an overall investment strategy to take advantage of anticipated movements in the price of underlying equities or to hedge their investments against such fluctuations. For example, some well known strategies are “butterflies,” “spreads,” “straddles,” “strangles,” and the like. Each of these strategies requires that the investor purchase and sell a number of different financial instruments related to the same underlying security. Orders for such transactions are called complex, combination, combo, or spread orders. For simplicity, these will be referred to herein as complex orders. Each purchase or sale of a security making up the complex order is referred to as a “leg” of the complex order.
For example, a “straddle” is an order to buy (or sell) a number of call option contracts and the same number of put option contracts on the same underlying security with the same exercise price and expiration date. A complex order to execute a straddle consists of two legs; the first leg is an order to buy, for example, two XYZ July 50 calls and the second leg to buy two XYZ July 50 puts. Such an order allows the investor to benefit if the price of the underlying equity XYZ goes significantly above or below the strike price of 50. An investor might place such an order if he anticipated high volatility in the stock price but wants to benefit whether the stock price actually rises or falls.
An investor could execute a straddle by making two separate transactions, that is, submit a buy order for the call options and submit a second buy order for the put options. The investor faces the risk that both transactions will not execute (or will not execute at the preferred price and time) and he will be left with only the put or only the call options. This is called “leg” or “market” risk.
Executing a complex order on known exchanges requires the services of a market professional called a specialist. The specialist receives the complex order and, if he feels it is profitable, executes each leg of the transaction himself or finds existing orders on the market against which he can execute the legs of the complex order. The specialist must devote considerable time and effort to evaluate the profitability of a complex order and/or assemble the necessary counter orders on the market. The specialist is able to command a high commission to execute such orders. In addition, the effort required to execute complex orders often results in these orders being “traded through” or passed over by regular orders that are later in time. Also, because execution of each leg of the order does not take place simultaneously, there is still leg risk. Specialists rarely assume this risk themselves, leaving this for the investor to face. As a result, complex orders traded on known exchanges were costly to investors, had reduced liquidity, and placed investors at market or leg risk.
As discussed above, complex orders can include both an option contract and the equity underlying that option. Two significant trading strategies in these markets include delta neutral trading and buy write trading. These are complex trading strategies, the primary purpose of which is to generate limited premium with limited risk. For example, an investor might wish to purchase call options in a stock and at the same time sell short a certain number of shares of the same stock such that upward movement in the stock price (which diminishes the value of the short sale position) results in a corresponding increase in the value of the call options. In order to achieve the minimum of risk, such an investor may wish to balance the price movement in its option and stock positions to achieve a “delta neutral” position by purchasing (or selling) a certain ratio of options contracts to stock shares.
Such trading strategies today have certain limitations, however, due to the fragmentary nature of markets. Since there is no single market for trading all types of financial instruments that can comprise a complex order, users of these strategies have added “leg risk.” This is because one leg must be executed at one market, and another leg at another market, usually involving different individuals and systems. As a result, two specialists or brokers must cooperate to execute this type of complex order, also resulting in less liquidity and higher commissions. In addition, because prices on both markets may fluctuate continuously, the final price for the complex order cannot be known until all legs are executed. Different markets may also offer different amounts of liquidity. This presents a difficulty in executing a complex order that requires a certain ratio of one instrument to another if the number of instruments on one market is insufficient to fully satisfy one leg of a complex order. If the amount of one instrument is limited, the amount of the other instrument purchased must be adjusted to achieve the desired ratio. This is also true for complex orders for other types of instruments (i.e., futures contracts and the underlying commodity, bond futures and bonds, and the like).
The options market first developed in the 1970s. Since that time, options for the purchase and sale of listed stocks have traded domestically only on floor-based exchanges, for example, the American Stock Exchange (AMEX). The method of trading options contracts in these floor-based environments is known as an “open outcry” system because trading takes place through oral communications between market professionals at a central location in open view of other market professionals. In this system, an order is typically relayed out to a trader standing in a “pit.” The trader shouts out that he has received an order and waits until another trader or traders shout back a two-sided market (the prices at which they are willing to buy and sell a particular option contract), then a trade results. In an effort to preserve this antiquated system of floor-based trading, the transition to and use of computer-based technology on these exchanges have been slow. Although some processes that take place on these floor-based exchanges have been automated or partially automated, they are not fully integrated and, in fact, many processes continue to function manually. As a result, there are many problems with the existing floor-based system that have caused large inefficiencies and inadequacies in order handling and price competition in the options market, and have harbored potential for abuse and mistakes.
These problems are particularly acute for complex orders. For example, most markets have rules which require that trades be allocated first to public customers and then to market professionals. In the rare instances when a specialist seeks to trade the legs of a complex order against other orders, he would need to assure that trades be allocated to give a preference to public customer orders. Market rules also require that trades be executed at the best available price, commonly referred to at the best bid or offer (BBO). On an actively traded securities, the BBO can change several times a second, making it extremely difficult for a specialist to effect such trades. BBO volatility also increases leg risk because the time between leg execution is likely to cause subsequent legs to execute at inferior prices, rendering the entire complex order and trading strategy unprofitable.
Beyond the trading processes internal to each option exchange, additional considerations arise when an option is listed on multiple exchanges. In order to assure that an order in a multiply-listed contract receives the best execution price, market professionals are charged with the responsibility of checking the other exchanges' prices, and may be required to contact the other exchange to verify that the prices are valid. Again, a specialist executing a complex order is faced with a difficult task. The process of checking other exchange prices is dependent upon the originating exchange market professionals' personal efforts to verify the other markets' prices. Where the complex order includes a stock leg, this problem is even more acute, since the stock transaction, as well as the option transaction must be executed at the best execution price.
The increasing volume of trades in options contracts, as well as the speed at which price information of underlying stocks is transmitted to consumers, has increased the demand for faster trade execution in today's market. In addition, volatility in the price of underlying stocks that are the basis for options contracts place further pressure on exchanges to execute trades quickly and at an equitable price. Market makers on floor-based markets are limited in the speed at which they can react to market fluctuations and respond with quotations. Moreover, the particular difficulties posed by complex orders drive up costs, decrease liquidity, and increase leg risk.